Trade with Pepperstone

How to Use Indicators to Implement Low Risk/High Reward Trade Ideas – Part 1

Let’s start by getting this straight. Indicators are not a magic bullet.

You are not going to find the key to trading success in some esoteric indicator combination – so best to stop looking now.

The great traders focus not on indicators, but on developing conviction in their trading ideas, position sizing, and psychology. What they care about is implementing their trade ideas in a manner that limits risk and maximises reward.

And this is where indicators can come in very handy.

They provide the structure to plan your trades, time your entries, cut your losses short, and let your profits run – all essential ingredients in a winning trading strategy.

Each indicator should have a very specific role to play

Have you ever been left dazed and confused by the conflicting signals that your indictors are sending you?

I know I have.

That was until I did two things:

Limited the amount of indicators that I had on the chart at any one time to a minimum

Gave each indictor I did retain a very specific role to play in my plan

When you add an indictor to the chart, make sure it’s necessary. Make sure it’s going to aid you in your decision making process.

Lagging vs. leading indicators

Some indictors are a rear view mirror into the past (lagging), while others are a window into the future (leading).

While the surface you may think that a leader indicator is better, both have their uses.

An example of a lagging indicator is a moving average. The moving average tell you the average price of the last X periods. This is very useful for determining the trend (see below).

Here is a 10 day moving average of the EURUSD.

Market Wizard Marty Schwarz was known never to trade against the 10 day moving average.

An example of a leading indicator is a displaced moving average. A displaced moving average is shifted forward in time so you can see the same trend projected into the future.

Here is a 25 period (displaced by 5 period) moving average on the USDJPY. Look to the hard right hand edge of the chart and you will see the moving average is in- front of the candles.

Big picture trend definition

While some traders make consummate contrarians, for most of us, letting the trend be our friend is the lower risk way to trade.

Indicators can be used to provide you with a non-discretionary way to define the trend. This can be useful both on the timeframe you trade off, and for higher time- frame big picture analysis.

You can adjust moving averages to capture trends of different lengths. The longer- term the indicator, the longer-term the trend.

Here you can see the 200 period EMA on the NZDUSD:

Vs. the 100 period EMA:

Vs. the 50 period:

As you can see, they all do the same job slightly differently.

Which one is right for you?

It depends on which type of trend you want so capture, so think about that first before you choose your indicator.

Changing the settings of your indicator

By changing the settings, you can adjust the signal the indictor gives you. For example, you can make an indicator more sensitive to a move, or capture a different length trend (see above).

Generally, the faster you make the indicator, the earlier it is going to give you a signal, but the more likely you are to be whipsawed.

Changing the settings on your indicator is quite simple in MT4:

Right click on the indicator on your chart

Select properties

Adjust the parameters

Some strategy: Use this indicator to confirm the long-term trend, and only place trades in the direction of the trend.

Timing a breakout or reversal

Some indicators are excellent tools for breakout and reversal trading.

If you are stalking an opportunity you like, you need a clearly defined entry point that allows you to be decisive when it comes time to pull the trigger.

If you are waiting for a breakout, the Bollinger Bands can be used. Once the price crosses and closes over the outer Bollinger Band, you can enter.

You can see on this chart of the AUDUSD the close over the Bollinger Band signals the commencement of a new trend:

And again here on the GBPNZD:

Stalking breakouts by waiting for a bona fide close outside the Bollinger Bands helps you to avoid being whipsawed by ‘fakeouts’.

Some strategy: Sideways (‘range bound’) trends work best here. Wait for the bands to be trending sideways before the price breaks out of the Bollinger band for a higher probability trade.

Managing false breaks

No matter how good your set-up looks, or how accurately your indicator is at predicting moves, there will be many occasions where the breakout or expected move fails and the trade goes against you.

These ‘fakeouts’ are a natural part of every trader’s day-to-day existence. The only remedy is risk management and foresight. Keep a stop-loss in place, and trade a small enough size that a loss won’t have a meaningful impact on your account.

Professional traders see losses like these as nothing more than a cost of doing business. With vigilance, risk management and good position-sizing, these losses can be wholly negated in the long term.

Catching a trend

There is no need to sit idly by watching the trend, wondering how to get on board.

Indicators provide a clear-cut way of implementing an entry during a trend.

Even a simple moving average cross-over can work well during a strong trend. To improve the risk/reward ratio, go down to a lower time frame.

For example, if there is a clear trend established on the daily chart, then go down to the four hour chart and look for a cross of the 3 period over the 7 period moving average.

Here is the 4 hour chart of the recent trend in the USDCAD:

Another method is to look for the price to pull back to a longer term moving average before entering.

On the EURUSD trend below, you can see several possible entries where the price pulls back to the 20 period moving average on the 4H chart.

This type of approach will mean you get in earlier than a moving average cross-over, but you will have losing trades if the trend does not resume.

Some strategy: Combine this approach with the Bollinger Bands. Once the price has broken out over the Bollinger Bands, go down to a lower timeframe and look for a moving average cross-over (or a pull-back) for your entry. Do this in the direction of the long-term trend as defined by the Ichimoku Cloud to further improve your win rate.

Just the beginning

This is just the beginning of how you can use indicators in your trading approach.

In the next article, we will talk about what is perhaps a more important way to use indicators – for your exits.

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